Corporate Debt Financing Decisions And Firm Efficiency

Agency cost theory suggests that a company's capital structure decision is essential to enhance organizational efficiency as the restrictive covenants in debt agreements can monitor the spending habits of the management and compel the company to follow efficient managerial practices.However,while debt may deter companies from making poor investments,studies indicate that it may also prevent them from making good ones.Accordingly,theories suggest that debt financing may have nonlinear effects on firm performance.In the first part of this thesis,we analyze how the use of debt financing determines organizational efficiencies and demonstrates the mediating role of corporate cash holding using data of the world's leading economies;namely China,Japan and USA.We find inverted U-shape relationship between the level of debt financing and the firms' efficiency suggesting that firms with optimum capital structure achieve high efficiency.Our finding is consistent with the prediction of agency cost theory,more precisely with Stulz model.The cash holding level of the firms negatively affects the efficiency.Theory states that agency conflicts are high when a firm holds more liquid assets because managers easily appropriate such assets for their own private benefits.Managers tend to engage in wasteful spending in cases where their firms hold high liquidity(cash balance)readily available at their discretion.According to the agency cost theory,the use of debt capital reduces the incentives of managers to expropriate value through large accumulated cash balances.We document that the firms that apply more financial leverage are less likely to hold excess cash balances and find that the cash holding partially mediates the relationship between the debt financing and the firms' efficiency.This suggests that the use of debt financing has the potential to enhance firm efficiency by effectively tapping the free cash flow that would have been misused by the management.In the second part of our empirical analysis,we examine how the use of financial leverage affects the productivity of capital invested.We gauge the productivity of the capital invested by employing Stochastic Frontier Analysis(SFA),parametric model to estimate productivity.We find that firms that use more debt financing are less likely to make overinvestment and are more likely to make underinvestment.Our findings suggest that the productivity of the capital invested becomes high as firms optimize their investment levels.Both over investment and under investment negatively affect the efficiency of the invested capital.In addition,we document that debt financing has a positive effect on the productivity of capital invested and that the effect is partially mediated by the investment of the firms.The third part of the thesis examines whether efficiency,in reverse,determines firm financing decisions and tests the bidirectional nature of the relationship.Firm efficiency positively affects the total debt and the short-term debt but affects negatively the longterm debt financing.Our findings indicate that high productivity improves the firm's short-term funding ability and increases internally generated funds.At the same time,it reduces long-term borrowing since the need for external financing decreases when firms have more internal capital.Moreover,where internal funds are not adequate,more use of short-term funding would offset the long-term debts required.Our thesis has important implications for corporate finance since it highlights how corporate financing decisions and cash management determine their productivity.This thesis contributes to the literature in many ways.First,it offers empirical support to capital structure theories that assert a non-linear relationship between capital structure and firm performance.Current literature lacks adequate evidence to support a theory based on a non-linear relationship between debt financing and firm efficiency.Second,most studies apply profitability measures,such as return on investment and stock returns,when conducting empirical test for the capital structure theories.We apply firm efficiency as a performance metric in our empirical test to examine the capital structure-business performance nexus.Specifically,our paper uses firm efficiency as a measure of(inverse)agency costs to empirically assess the predictions of agency cost capital structure theory.We estimate the efficiency using stochastic frontier true random effect(SF TRE)model,a model that disentangles time-varying inefficiency from firm-specific unobserved heterogeneity.Third,although there are well-established theories explaining how free cash flows affect efficiency,the mediating effect of cash holding for the association between financial leverage and efficiency has not been tested empirical data.We show the mediating role of cash holding.Furthermore,this study provides important contribution by systematically gauging firm efficiency and testing its impacts on firm's debt financing decisions.To researchers' knowledge,firm efficiency as a determinant of capital structure has not been sufficiently analyzed with empirical data.We show how companies' productivity level affects the debt financing decisions and evaluate the capital structure theories from this viewpoint.The analyses show that debt financing has important implications for firm efficiency.We demonstrate the benefits of debt for reducing agency cost by disgorging the free cash flows that would have been misappropriated by managers.The findings of this study offer valuable lessons for corporate owners,board of directors and other stakeholders who are concerned with protecting businesses from potential managerial expropriation.Debt is a strong form of commitment and it constrains managers to meet payment terms.Managers are thus forced to make wise investments.To monitor managers' spending behavior thereby avoiding unwanted expenditures,companies shall apply debt financing as one of their control mechanism.Besides,the study examines the bidirectional nature of the effect whereby firm efficiency,in reveres,determines the use of debt financing.The result suggests that a firm's level of debt financing is affected by different factors including the firm's efficiency.Therefore,in their debt financing decisions,managers should consider the firm's productivity level among other factors.